“…it is all too easy to hold on to a winning stock for too long without taking at least some gains. But it is even more important to have a clear idea of how much you are prepared to lose…”
In this third in a series of six articles, we look at how you can look to trade the Markets, be it full time, part time or occasionally.
Every one reading these articles will be at a different level compared to the next man. Fundamentally the rules are the same. Over 80% of retail “punters” lose money. Hopefully, here, we will try and help you be in the 20% that doesn’t.
We will cover different strategies, ideas, entry and exit plans and try and get you to just think a little more before giving your hard earned cash away. There is no right and wrong way to make money in the markets. Find a strategy that works for you.
The markets have been around for centuries, they are not going anywhere so take your time with your research. There is a plethora of information around these days with the advent of social media and the internet, use it. Ensure you have an exit plan. Any fool can buy a share, the trick is selling higher than you bought. We hope you find some benefit in one or some of the articles. The third article here features another very important topic : Position size
“…Investors can organise their portfolio to find a balance with which they are comfortable, apportioning sufficient capital to each trade to give it space to grow and yield a decent return, while limiting the damage unsuccessful trades can cause…”
Our first two articles introduced essential risk management principles that should be observed by both day traders and longer term investors.
As we discussed, you should certainly enter a trade with some idea of your desired return: it is all too easy to hold on to a winning stock for too long without taking at least some gains. But it is even more important to have a clear idea of how much you are prepared to lose. The market will always present new opportunities. Your first job is to protect the capital that allows you to stay in the game long enough to take advantage of some of them.
The limits of stop-losses
Our last article discussed using stop-losses to limit damage sustained from a losing trade. Today we consider the proportion of your capital you should allocate to a particular investment. A stop-loss is an essential safeguard but it will not protect you from taking a big hit if you have to allocate a substantial proportion of your capital to a single trade.
Say, for example, you commit £5,000 of a £10,000 portfolio to a trade, and set a stop-loss of 10pc. If the share disappoints and hits your stop-loss price your loss will be limited to £500. Disaster is avoided. And even if you continue to make such big trades stop-losses will give you a fair amount of protection. If, with your portfolio now down to £9,500, you go ahead and put commit 50pc of it to a £4,750 trade, a 10pc stop-loss will cut your loss to £475, £25 less than your last trade. The pie is smaller, so you lose a little less each time.
But even so, after just two trades you are 9.75pc down, to £9,025. A few ventures on this scale will run your capital down unnecessarily quickly. Your challenge is to commit enough capital to a trade to allow for the possibility of a worthwhile return but not so much that you soon finding yourself so far down that you start to need a few spectacular winners to get back even. As any gambler knows, when you find yourself in that position it is all too easy to start getting desperate.
A formula for calculating position size
One common way of managing this risk is to ensure your holdings are of a similar size. So – to illustrate it in the simplest terms – we might divide our £10,000 portfolio between 10 holdings, with a book cost for each – the amount paid for them – of around £1,000.
If a stop-loss is applied to each holding a simple approach like this can work well. Investors can organise their portfolio to find a balance with which they are comfortable, apportioning sufficient capital to each trade to give it space to grow and yield a decent return, while limiting the damage unsuccessful trades can cause.
But day and currency traders have developed a rather more rigorous methodology that is useful for investors of all kinds. The idea is that the number of shares you buy in a particular stock – your ‘position size’ – should be determined by the amount of capital you are prepared to lose if the investment doesn’t work out. Position size is calculated using this simple formula:
Monetary Risk / Risk Per Share = Position Size
‘Monetary risk’ is the amount of capital you are prepared to lose on a single trade – the slice of your portfolio you are prepared to write off. Your monetary risk will depend on how confident you are that the trade will work out well, and how much you can afford to risk. A common rule of thumb is to limit your monetary risk to 1pc or 2pc of your portfolio.
‘Risk per share’ is the price at which you buy the shares – its ‘entry’ or ‘bid’ price – minus your stop-loss price, the price at which you will bail out and sell if it isn’t working out. The formula can be easily grasped through a couple of simple examples.
Returning to our imaginary portfolio of £10,000, let’s say you are prepared to risk losing 2pc of it on each trade. Your monetary risk, therefore, is £200 (2pc of £10,000). Imagine the share price is 100p. If you set a 10pc stop-loss, your stop-loss price – the price at which you will sell the shares – will be 90p. We now have the variables we need to run the formula Monetary Risk / Risk Per Share = Position Size:
£200 (2pc of £10,000) / 10p (100p – 90p) = £2,000
With a share price of 100p £2,000 buys us 2,000 shares.
By using this formula we are able to commit sufficient capital to open the possibility of a good return but have minimised our possible loss. £2,000 is a fifth of our £10,000 portfolio, but by setting a stop-loss price 90p we ensure we only stand to lose £200. Our portfolio goes down just 2pc, to £9,800.
The position size formula is straightforward enough to run through a simple calculator, but if you want to try out different parameters quickly you can use one of the many position size calculators available online: there’s a nice simple one on Investor’s Chronicle writer Matthew Taylor’s website.
Let’s consider an example that looks a bit more like a real world trade. imagine you have a £50,000 portfolio and are prepared to lose 1pc – £500 – per trade. After accounting for your platform’s trading commission, say £10, your monetary risk is £490. The share you want to buy, let’s say Unilever (LON: ULVR), costs 3,768p (at the time of writing). Your stop-loss is 10pc, so your risk per share (rounded up) is 377p. That means your stop price is 3,391p (3,768p – 3,391p). Running those figures through our formula Monetary Risk / Risk per Share = Position Size we come to £490 / 377p = £4,897, a sum that allows us to buy 130 shares.
Again, you can see that you have scope to make a substantial investment while minimising your risk to a few hundred pounds. But – and it is a big but! – it only works if you have the discipline to leave at the stop loss price. If you don’t a big outlay may become a big loss.
Calculating account risk
Before committing to a trade you might want to make another quick calculation to check the total amount of your portfolio you might lose if you were to lose 100pc of your investment in a trade – usually referred to as a trade’s ‘account risk’. This can happen if you don’t have the opportunity to exit at stop-loss price, if for example the stock is suspended and delisted. Note that you can’t lose more than 100pc: retail investor accounts are protected by European Securities & Markets Authority MiFID-II legislation which protect retail accounts from negative equity.
You can work out a trade’s ‘account risk’ through another simple calculation. Say you are prepared to risk losing 2pc – £200 – of a £10,000 portfolio on a trade. Divide that by our example entry price – 100p – and you’ll find you should buy no more than 200 shares to ensure no more than £200 risk. The calculator on Matthew Taylor’s website also allows you to work out account risk.
Things to note
It is very important to note that stop-losses are not necessarily fail safe devices. As we discussed in our previous article a stop-loss won’t guarantee against events that might affect a share price outside market hours. If, for example, a company in which you are invested issues a profit warning in the evening its shares could trade the next morning at a significantly lower price than your stop.
You should also note that if you decide to change your stop loss price once you have entered a trade the monetary risk part of your position size calculation will change. If you adjust your stop-loss price upwards to follow a rising share you will need to recalculate your position size if you want to keep your monetary risk the same.
For example, if a share you bought at 100p now sells for 150p and you reset your stop loss price to 135p (10pc of 150p is 15p) you will need to change your holding to 3,333 shares, at £5,000 cost, if you want to keep your monetary risk at £500. Your shares in this stock, and hence your portfolio, are now worth more than when you first bought them, so you would need to buy more of them if you want to retain the same monetary risk. Clearly you don’t need to do this: you can just enjoy the fact that your original monetary risk has gone down because the value of your shares has risen.
You may not want to assess all your investments according to a formal metric like a position size calculator. Many investors allocate a substantial portion of their portfolio to passive funds that track global markets, a particular market, or an investment theme. They are prepared to allow the value of these key holdings to fall for periods of time, ring fencing them from that segment of their portfolio dedicated to bolder investments, to which the position sizing calculations discussed in this article would be more rigorously applied.
The balance between conservative and more dynamic holdings depends on an investor’s risk profile. Generally speaking, those prepared to wait longer for a good return are more risk tolerant, and those seeking to protect their wealth over a shorter time horizon are more risk averse. We will discuss risk tolerance and portfolio management in our next article.